If you follow the stock market, you may know the passive vs. active investing debate has been going on for a while. Ever since the creation of index funds — the first passive investing option — experts have been arguing for and against the strategy.
So, which is better? It all depends on what’s right for you and how it fits with your own investing strategy.
What is Passive Investing?
Whenever you hear reports on “the market,” they’re actually referring to a subset of the market represented by a market index that tracks a smaller group of stocks. The three indexes you’ll most often hear about are the Dow Jones, S&P 500 and Nasdaq. Each is a key representative of the stock market and serve as a benchmark for the U.S. stock market’s overall performance.
Passive investments, which involve buying and holding investments for a long period of time (like index funds or ETFs), try to mirror a stock market index.
To do this, the fund manager buys all, or a good sample, of stocks or bonds from the index, and holds onto them. The goal is to match how the index performs over time. Your returns will be comparable to that part of the market.
Passive investing continues to grow in popularity for several reasons:
Low cost - Index funds and ETFs are generally less expensive. Because they require less management, and expense ratios are lower. Knowing what you pay in fees is important because it can add up to a lot more than you think.
Transparent - Passive investing is simple and easy to understand. If you are curious about the underlying investments, you can see holdings in both active and passive funds.
Tax efficient - Depending upon the type of account, selling investments may trigger a bigger tax bill. But passive investing generally involves less selling. So, it may not be as much of a concern.
These are strong selling points, but there are shortfalls, too. There is rarely opportunity to outperform the stock market. And when the stock market takes a nosedive, it may be harder to cut back on losses.
What is Active Investing?
Active investing is exactly the opposite approach. Fund managers are much more involved.
They do a lot more buying and selling within the fund to try and beat their specific benchmark.
Some of the benefits of active investing may include:
May outperform the index - With the expertise and hands-on strategy of an experienced fund manager, it may be possible to earn better returns than the market. However, most managers have struggled to outperform their benchmarks on a regular basis.
Possible to reduce losses - No one can predict what will happen in the stock market. While there is plenty of upside potential, there will be down years too. In these scenarios, active managers may have the ability to reduce losses.
Often, the biggest complaint about active management is the cost. It's a lot more expensive without the guarantee of better performance. Funds may also fluctuate when an analyst or manager changes firms.
How To Choose Between The Two
You may be eager to decide whether active or passive investing is better. But like many aspects of personal finance, there’s no clear-cut answer. And it may change depending on your age, goals, net worth, and timeline.
When you are less experienced, you may prefer the simplicity of passive investing. With less to invest, low fees and transparency may be a good fit.
If your situation is more complex, or you have a higher net worth and are willing to take bigger risks for potentially greater rewards, you may need more custom options that come from active investing.
Your choice doesn’t have to be mutually exclusive. Because every asset class is different, you may like a buffet-style portfolio with a mix of passive and active investments. If the decision feels overwhelming, you can always talk with an investment professional for help and guidance.
This material is not meant as investment advice and is for informational purposes only. Please consult a financial professional before making any investment decisions.
Holdings in index funds may not exactly replicate the benchmark and investing in these type of funds still involves risk.
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